How do you make more money from the market? Probably not the way you hope to...

One of the greatest cons at the heart of the typical investment sales pitch is that there is a positive trade-off between risk and return - that the more risky the punt you take, the greater your returns will be. This fallacy has become so pronounced that some fund selection platforms have started to publish a slider in the user interface from low risk / low returns to high risk / high returns. As if you can just dial up a certain level of profits for a certain level riskiness. Bah humbug !

This screwy thinking had its origin in the 1960s when some extremely bright academics, probably a little concerned by their diminutive faculty salaries, decided they needed an idea to sell. They came up with the 'efficient market theory' - which boils down to this idea that you can only gain higher returns by taking on more risk. This kind of neat idea sounds wonderful to the investment industry which just adores selling high margin, high risk investment products - so they were very willing customers. Many of these academics became obscenely rich.

Unfortunately the idea just didn't work. Over the last 30 years there has been a growing chorus of dissent against the efficient market theory as practitioners have discovered something quite unusual. In practice, investing in low risk shares generates higher returns than investing in high risk shares. The slider works the other way around!

Warren Buffett, the richest investor in history, dialed up his own fortune by standing diametrically opposed to these ideas. A famous study called "Buffett's Alpha" attempted to reverse engineer his investment style - discovering that to achieve his level of extremely high returns required systematic investment in low risk, high quality stocks. Are there any billionaires with his kind of long term outperformance that have ever won by consistently investing in high risk shares?

The gamblers fallacy

Why should safe, low volatility shares outperform? It most likely comes down to the fact that people love to gamble. Think about it - how much more interested are you in investing in the stock market when the stock market is going up? And when you start to get that itch, which kinds of stocks do you feel you want to start buying? If you are anything like the majority, it's the stocks with the highest likelihood of doubling in the next few months. The eye is inevitably drawn to story stocks with blue sky potential - intrepid exploration stocks, biotech innovators or space age tech.

Advertisement

And it's not only private investors who buy these stories, it's fund managers too who are so scared not to participate in the hot fads of the day - after all they have their Christmas bonuses to think of - it's safer to just join the party.

So there is a tendency for investors to misallocate their savings away from owning shares in unexciting, safe stocks (the ones that Buffett showed win in the long term) to the exciting, ziggy-zag stocks that seem more likely to win in the short term. As a result, safe stocks tend to sell too cheap and risky stocks tend to sell too expensively. Learning to stand opposed to the crowd is almost always the best thing an investor can learn to do and this 'inefficiency' is no exception.

Don't just take my word for it

There's been a brilliant paper just published by some of the same authors of the 'Buffett's Alpha' paper that they've titled 'Quality minus Junk'. In it they show that low risk, high quality stocks outperform risky, low quality (junk) stocks by 8.5% on an average annual basis globally. While these higher quality stocks are indeed generally more expensive (on a valuation basis) than the low quality stocks, they aren't priced highly enough. Beyond this, the authors show that the returns to buying cheap stocks can be significantly improved by filtering further for quality.

These are the kinds of strategies that we promote at Stockopedia using our sophisticated ranking and screening systems. In fact many of the same factors across profitability, margins, stability, bankruptcy risk etc that are used in the paper above to define quality we had already included in our algorithm for the Stockopedia QualityRank.

As Warren Buffett has said, investing is 'simple but not easy'. The simple part is having a consistent process to build portfolio with a good chance of beating the market, the most difficult part of it is saying no to all the traps and temptations that lie along the way.